Bitcoin’s Deflationary Economy Not A Problem In Itself

42

Swarm Economy

Swarm Economy

When discussing the distributed cryptocurrency Bitcoin, I frequently get the question from reporters and economists if a deflationary currency really can survive.

It’s an interesting thought. We’re so used to living in an inflationary economy, where money gradually loses its value, that we have a hard time imagining what it would be like in an economy where a certain amount of money slowly became more valuable as prices fell.

Since we have only lived in inflationary (and hyperinflationary) economies, there are bucketfuls of assumptions of why a deflationary economy wouldn’t work. The strongest objection I hear is that nobody would buy anything today, since the same thing would be cheaper tomorrow. And they wouldn’t buy it then either, because it would be cheaper the next day again. And so on, so nobody would buy anything, ever: we would all be waiting indefinitely for everything to drop in price.

No, really. This is an argument that’s being presented as absolutely serious and spoken like an undeniable truth.

Conversely, the only reason we buy something today must therefore be that it will cost more tomorrow, and even more the day after, so we must hurry to spend our money: that is the only reason we would ever buy something. (It is when the argument is reversed, that its somewhat… narrow… point of view is exposed.)

But the assumptions fall earlier than that: they fall already with the premise that we’ve never lived in a deflationary economy. While the economy as a whole may not have been deflationary, parts of it have been for decades.

So let’s assume just for a second, that if a specific thing you needed would cost less in three months, you would wait to buy it. In three months, you would repeat the exercise and wait for three months more. If there was a particular type of item that would just cost less and less, nobody would never buy them at all. If you subscribe to this view —

What are you using to read this article?

Electronics have been deflationary since the 1970s. A gadget with a certain performance can always be bought much cheaper a few months later, and for practically zero cost some two years later. This is deflation. Prices fall and your money becomes more valuable. Maybe this is not just deflation, this is even approaching hyperdeflation.

In this scenario, using the argument above, nobody would buy any electronic gadgets since they can be had cheaper a bit later; everybody would hold on to their money. So are you buying any gadgets? Again, what are you using to read this article?

In reality, Apple Computer Co. is the world’s most or second-most valuable company, competing with an oil giant for the top spot. And Apple is operating in a deflationary sector of the economy.

Bitcoin may have its flaws, but its deflationary characteristic is not one of them.

The argument against deflation may have one point correct, though. In a deflationary economy — and we see this coming true with electronics, too — people are not buying more than they need at the moment, since it will be cheaper to buy for next year’s needs when next year comes around.

But people only buying what they need — is that really a bad thing?

You've read the whole article. Why not subscribe to the RSS flow using your favorite reader, or even have articles delivered by mail?

About The Author: Rick Falkvinge

Rick is the founder of the first Pirate Party and is a political evangelist, traveling around Europe and the world to talk and write about ideas of a sensible information policy. He has a tech entrepreneur background and loves whisky.

42

Well, first off: We HAVE lived in deflationary times, the Great Recession and the current World financial Crises being the most significand. Those were only mildly deflationary, but still severe in its effects.

Second: the argument actually goes sligthly different: In a deflationary environment you are not going to INVEST anymore, because holding money gets you more benefits than investing it. That’s the problem and we’ve seen in the 1930s and in 2008. Too, it’s the reason why deflation was biggest in asset prices and not in consumer related stuff.

However, the most significand problem of BitCoin might be, that there is no economy that accepts it _as currency_. Yes, there are shops that will take BitCoin, but in reality they’re still Dollar/Euro-based. There might be, however, an illegal market for drugs etc, but that is yet to see in my eyes. My best guess is that this will not happen either, as no currency with fixed supply has ever survived the course of history without the help of the state. Also, markets for food and housing are still in Euro/Dollar/other Currency, which is a big obstacle for BitCoin.

This implies that the only reason people invest is because it will net them a monetary return.

Yes, admittedly, that’s a much bigger reason for investment, but there’s still a significant number of investors (probably a minority, but I’m not sure) who simply want to see the company/product/thing in which they’re investing succeed. That success is the return on their investment; if it makes them money, that’s just a bonus.

Deflationary currency certainly would make pure speculation a much sillier idea. But is that really a bad thing?

Regarding unwillingness to invest, that is dependent on what level of return the investment can give. The money returned by the investment will also be more valuable as time goes by, so it will still be better to invest than just sitting on your money, and definitively more interesting than consuming them. Rather I think the interest in investing would go up, as that is better than consuming, the investment will return even more valuable money at some future date.

The problem would rather be that if consumption is lower due to people waiting as long as possible to consume, the demand for investments to meet consumption demand will be lower, so investment opportunities will be fewer, and there is a risk that the whole economy will be slowed down due to this.

Regarding BitCoin, to me it looks like it is traded more like a commodity than a currency, kind of like gold, but with the distinct difference that BitCoins have no inherent usability that is ultimately driving the demand. Gold is valuable because it is scarce and usable for a number of things, BitCons are just scarce, their value is upheld _only_ by the expectation that they will keep their value, that there will be a future demand, There is no industry that ultimately need bitcoins to make bitcoin plated contactors… So should the market collapse, there is no demand whatsoever to make it reboot, there is nothing that could be done with bitcoins only.

I think that, ultimately, the fact that bitcoins have become almost entirely a speculatory commodity, will be its undoing. Had it happened the other way around, first a genuine market that actually needed bitcoins as its currency to work, it would have been another thing. As it looks now, my guess is that it sooner or later will collapse to nothing and won’t be able to resurrect itself.

If there is economy behind currency it won’t collapse. Currency can be hyperinflated but it won’t collapse by itself – no paper standards have every collapsed just because paper have no intrisic value. If currency is not enforced by government it will find its natural niche on the market, if the currency is competitive market will embrace it. The speculation behind bitcoin is sound, those who see what it might become don’t hesite much to put their money in. It is just a matter of time…

If I understand you correctly, with your assumption, people would only invest in gold, wouldn’t they? In reality, there are usually better investment opportunities than gold, and people do invest in them. The fact that bitcoin is deflationary (well, actually the money supply is inflationary but value will go up in time if more people use it) doesn’t really mean that it’s a better investment than any possible thing.

Secondly, historicism just isn’t. :-) Bitcoin is pretty much different in every aspect from every other currency, with the exception that it’s scarce, so it may very well be the first currency with fixed supply that survives. Also, of course there is no (or a small) economy that accepts it, because it is very new, very revolutionary, hence very risky, and is not being violently pushed by an authority. We need to be more patient.

@Jörgen L: Yes, if Bitcoin collapses in the real sense, it won’t recover, period. Though I think Bitcoin is more useful than you give it credit, and when the mist of suspicion around it is dispersed (in a few years) and ordinary businesses begin to try it out, we’ll see its true value.

Deflation happening during the Great Recession was caused in part by the decrease in money supply and not because of increased productivity making your money worth more.
This is very different from price deflation which wouldn’t hurt anyone.

Luckily the number of bitcoins in circulation can’t easily be manipulated by the banks/government since they are not created out of debt, Events like we have to day and the 1930’s is far less likely in a bitcoin economy.

The argument that nobody would want to invest in a price deflation economy because saving is more profitable is obviously wrong. If nobody invested then the value of the currency would not increase either.
So the market will find an equilibrium between investments and savings. If everybody saves there will no no benefit to saving anymore.

The so called “growth” might be less but I think we will get more sound investments since they compete with other investments through deflation/savings. Deflation is a true measure of increase in productivity. Stockmarkets “value” and debt isn’t. And we may see more investments not purely motivated by greed/profits. All this would be a good thing if you want a stable and sustainable economy.

The Bitcoin economy is coming; we all just need to be patient for a few things to be developed.

Merchants need a secure way to store their Bitcoins, a reliable and trustworthy mechanism to convert them into other currencies, and plugins for their existing merchant platforms.

And consumers need easy ways to get their hands on Bitcoins. It’s currently very very hard to buy Bitcoins, and the transaction fees are excessive. The situation is getting better, quickly, but it will take time before you can go to your ATM and have Bitcoins transferred to your address.

These things are coming. It will take time, but when they are in place, the low transaction costs engendered by the Bitcoin system, and the lack of “chargebacks” will incent many many businesses to start taking Bitcoins for payment.

The fact that bitcoin is not very widely accepted is not a problem, though many mistakenly think it is. Look at it this way: Is the fact the gold is not widely accepted a shops a problem for the perceived value of gold as a currency/store of value? No it is not. As Greshams Law states: “bad money” will typically drive “good money” out of the market. http://en.wikipedia.org/wiki/Gresham's_law

Take an example: If you had in your pocket a 1 oz gold coin, (valued at approx $1,000 a few yrs ago) and 1,000 dollars in federal reserve notes, and you wanted to purchase an item for the same value. If the seller would equally take either gold or federal reserve notes, and if you thought that in the future your gold would be more valuable than your FRNs, then you would part with your FRNs and keep you gold, correct? Ok, multiply this by an entire population and you have an entire market exchanging FRNs and hoarding gold. There would be no demand coming from consumers to be able to transact in gold. And sellers would conveniently continue with the current system of accepting the FRNs and would simply adjust prices to make up for any loss in the FRNs value in the market. Not until the pressent currency becomes so unstable and rapidly declining that sellers could not trust their future short-term/medium term value will sellers demand to be paid in an alternate currency. That is went “good money” (an item that is not easily reproduce-able and thus is a stable unit of account) will be “forced” out of “strong hands” and into the market.

Given what I have stated above, I think the fact that bitcoin “good money(?)” is not currently widely circulated indicates that it’s future is currently valued higher than the currently accepted exchange mediums.

I think it is not only a matter of good vs. bad, sound vs. unsound money. It is also matter of conveniency. Paper money are more efficient in transactions than gold. In this sense bitcoin is far more efficient in online world than any other currency or system. Since it is superior in efficiency and it can be trusted the same way gold can, there is no dichotomy as with gold, which is good store of value but not as efficient as paper money in transactions, there is no dichotomy in good in short term, bad in long term.
Another feature with paper currencies is that they are enforced by government from obvious reasons and any sign of competition is prosecuted. Take e-gold for example. Bitcoin will be much more hard to close down. Since bitcoin is just an idea or principle, once it is here and we like it, it is nearly impossible to eradicate. I claim that governments lost the battle the minute Satoshi’s paper was published.

Well, even though one must admit that inflation or delfation is not bad in itself, the intrinsic flaw in bitcoin is more about the assymetric way of money printing.

What justify the fact that early adopters could earn a lot of bitcoins at first when now it got really hard to get as rich as them ?

An eligible currency in a democratic society should not provide any privilege to some citizen. But in the case of bitcion, it is obvious that some people – early adopters – take more benefits of the system compare to others.

The 21 millions limit is the issue : what will happen to early adopters’ children when this limit is reached ? Basically, they wil have to get indebted first before starting to participate in the bitcoin economy.

Is that fair ?

You mention in another post the idea of the basic income as a new fiscal policy in cryptocurrency (and i totally agree with this). I would suggest to go further. Why not applying a basic income, financed by money printing ? This way, you don’t even need a taxation system as inflation becomes the main tax.

And thereby, every participant – regardless of when they joined the system – are equal towards the money creation.

(NB : i am actually talking about the concept of the “social credit”, which was claimed in the 30s notably in Canada as an alternative of the money-debt banking system : http://en.wikipedia.org/wiki/Social_Credit )

By what standard are you judging fairness? If you are hinging your ethics on modern capitalism and the supposed sense of “equality” in democracy, take note that in America, the top 10% wealthiest people own over 70% of all total wealth.

Is that fair?

You seem to have mistakenly identified democracy for a guarantee of equal wealth as opposed to one of equal right to wealth. And capitalism has always rewarded those who act on their right to wealth.

Every time there is new idea which becomes very valuable afterwards, the early adopters benefit. It is not “just”, it is not safe, but it is risky. When somebody finds gold or oil in his garden it is not more “just” than this.
New participants will always BUY bitcoins the same way most of us buy gold if we want to transact in it or hold it. They can even WORK for bitcoin… This is how people get in economy of arbitrary currency. Bitcoin is only new currency so anybody can transfer any amount of wealth in it, if he chooses so.

Bitcoin transaction will occur verus other payment methods because the costs when transaction using bitcoins are lower.

When I am at a gas station, for instance, I see one price if I use my credit card, or a lower price when I pay cash. ECommerce merchants haven’t before had the equivalent of being able to offer a discount for those paying with cash,

As long as I can easily replenish my bitcoin holdings, I would have no concern that using my bitcoins would cause me to miss out should the value of bitcoins increase.

Those other flaws are mostly FUD.
The only real problem tht article mentions is the delay until confirmation. Real world experience will show whether that’s a real problem; if it is there already is at least one alternate (SolidCoin) that tries to fix this.

Bitcoin won’t be truly deflationary till meet reach the 8th decimal. The # in bitcoin are the amount of network transaction you can do. When other currencies are worth a fraction of.00000001 bitcoin then there will be deflation.

8th decimal place is not ultimate, the protocol can be seamlessly expanded to 16 decimal places. But even if this wasn’t the case, it wouldn’t affect its deflationary character > take gold for example, its divisibility is bounded for practical reasons, still its value can grow without any bound. So deflationarity is not affected by limited divisibility. What is affected is the minimal practical amount of gold with makes sense to transact in real world. But if we deposit the gold in bank and make digital transaction in “gold Visa” account we gain in theory unlimited divisibility for gold. So divisibility is not issue at all, we can always issue new digital currency back by gold or bitcoin.
Issuing new currencies backed by bitcoin is taking place even now: take flexcoin for example. New currencies backed by bitcoin will enpower bitcoin base by features which bitcoin itself lacks: instant transfer, reversibility (where needed), true micro payments and so on and on. The great thing about bitcoin is that is VERY SOLID MONETARY BASE as the gold once was (and it may still again become).
Bitcoin advantages to gold are >
1) “zero” costs for storage
2) limited security costs – software and hardware is cheap, we need just to learn how to secure it and then spread the knowledge
3) its depository is delocalized in the community net, so it is everywhere where you can access internet having your private keys.
4) you can create offline depository, never to be connected to internet
5) you can create transactions and sign them offline, so your private keys never get in touch with internet
6) you can write the private keys and create transaction on paper and send them by mail, you can send the keys or transaction through by sms or email
All these features are so revolutionary that one can’t even imagine all possible use of it…

At this point, most money is just numbers in a database. For one bank’s database to talk directly with another bank’s database they must ‘trust’ each other. With bitcoin, it’s not needed. Send money anywhere in the world for cheap – as long as there is a local exchange that can cash you out – your set. It will bring down the international wire monopoly (and more) like Skype brought down the international calling monopoly.

My model of bitcoin as currency is following:
1) there is a core bitcoin community who trusts it as a currency, the trust is based on sound (although somehow “new”) principles
2) bitcoin has unprecedented competitive features: fast, super cheap, can’t be manipulated at will
3) bitcoin is evolving very fast, a lot of new tools and phenoma are arising above this platform
These are facts that cause that more and more people (users, developers, investors) are falling into bitcoin
As more and more people wants to hold bitcoin (for shopping, investing or speculating), it is becoming scarcer and scarcer and thus it is gaining value. If value of bitcoin overshoots in bubble, so it is not anymore supported by the size of economy, bubble will burst, but it won’t go to zero unless there is any economy behind it. Since transactions in bitcoin have a lot of advantages to other means of transactions, the size of bitcoin economy will probably grow, so will the value of it.
In my opinion bitcoin would even work if it wasn’t purely deflationary, Because it is so cost effective that it would attract merchants anyway. This is why we use paper money and not gold – even if it looses value, it is really easy to make transactions with it. Bitcoin is both: it makes transaction around the world easier and cheaper, and it gains in value if the economy is growing.
In my opinion the currency is just a mean of transactions, if not manipulated, defrauded or enforced by central bank or government, market would pick the one which is most effective in doing so. I can see a lot of reasons why bitcoin could be the market’s number one.

Rick, great article you have written. I think it’s very accurate.
In reading the comments, it’s always amazing to see how everyone knows the flaws and predicts the downturn of this brand new medium. “the most significand problem of BitCoin might be”….”the intrinsic flaw in bitcoin is” Yet Bitcoin use continues to grow, software integration and new gadgets abound and more strength comes into the exchange market each week. Yes, amazing how something so “flawed” can have such success! I wish my career had such flaws:-) GO BITCOIN!

For those who argue that deflationary feature of bitcoin will make it hard anybody to take a loan in bitcoin, I have following arguments:
1) once the size of bitcoin economy is stable, market will take care of the rate of interest – we can argue that the interest for deflationary currency will naturally much lower than for inflationary currencies.
2) if market wants to buy 10-year US treasury with 3% rate while real inflation (not that reported by government) is more than twice as high – i.e. negative real rate, it will probably accept 0,5% – i.e. very small positive.
3) sure there will evolve derivates in market, which will take care of deflationary risk, the same way as futures take care of price volatility risk.

You are misunderstanding me. I don’t claim that inequalities shouldn’t exist. I claim that in a Democracy, the currency system shouldn’t not treat citizens differently. So, if money has to be printed, then it should be given to everyone as a monetary dividend, and not given to some guys under the pretext they are “early adopters”.

But of course, this is difficult to understand for bitcoiners, because most of them i’ve been talking with do not see bitcoin as a democratic currency. Rather they envision it as an interesting commodity on which they can speculate and eventually get rich (which is not bad, again. But this is not the purpose of money to make people rich or poor. Money is just an exchange protocol. people should get rich thanks to theirs talents and what they offer on a market)

On the contrary, money printed by the government is first given to the government. Inflation can be seen as a tax on those who hold money. as opposed to assets, since every time the government prints money they get a fresh supply of bills while people with money get slightly poorer. This is why printing money is often used in monetary policy as economic stimulus, since inflation will “tax” the money you hold. Personally, I’d rather have the money go to early adopters than to dubious bureaucrats.

Money is not only an exchange protocol, it is also financial capital. There are hordes of institutions out there whose sole purpose is to make money through the management, exchange, loaning, and borrowing of money. Banks thrive because they can loan, for a price, money to those who need them; stock markets exist because people can invest money in companies for a return.

In that respect, I see nothing wrong in people seeing Bitcoins as an investment tool, considering that they have to bear the risk of holding on to digital data that could become worthless if the market decides so. On the flip side, there is a huge discrepancy between newcomers and early adopters, and the system could’ve been better designed to address it (which is the point I think you are trying to make). However, this gap is in part due to Bitcoin’s explosive growth from a media effect which alerted investors of an undervalued commodity, driving price up immensely. This is an sort of explosive growth is certainly not an easy thing to predict, but did greatly benefit early investors. It is easy for us to retrospectively scapegoat early adopters as colluding with the system, but a year back it might have been utterly ridiculous for someone to think Bitcoin would have gotten as far as it has now (certainly not the guy who paid 10,000 btc for pizza). Many people claim the system as unfair when early adopters simply benefited from a lucky break (or a very, very meticulously planned scheme).

Bitcoin awards early adopters precisely because it otherwise has little way to encourage growth in a userbase which must compete with the predominance of physical currency, especially when costly hardware is at the core of the system. Thus, some discrepancy between early adopters and newcomers is inevitable for progress. Whether Bitcoin has benefitted early adopters more than it should have is subject to endless debate, and not something I want to comment on.

I’m not quite sure I understand your idea of a “democratic” currency, would you care to elaborate?

Democracy is based upon the Declaration of the Rights of Man and of the Citizen : “Men are born and remain free and equal in rights.”

some consequences :

* is access to the monetary system a right ? I think so. A society in which 90% of the money is hold by 1% of people is not standable.

* granting access to money creation to some people and not to their children does not respect the equality of rights. Doing so, you’re denying the rights of the future generations.

* “Personally, I’d rather have the money go to early adopters than to dubious bureaucrats.”. This looks the same for me : in all case, some people are taking advantage of an undue privilège. The best way to avoid this is to give everyone a dividend. No privilege, no jealousy,

* “Bitcoin awards early adopters precisely because it otherwise has little way to encourage growth”

If you really want a cryptocurrency revolution, then the people gathering around bitcoin or others shouldn’t be attracted by profit. rather they should be motivated by political/social believes, and financial benefit should be a bonus rather than an objective. but obviously, it will take more time than you expect… So now the question is : do you want banks & governments to LOSE ? Or do you want citizens to WIN ? Both are not necessarily related (everyone can loose).

* “some discrepancy between early adopters and newcomers is inevitable for progress”

Of course, one day to another the early adopters take advantage of their position, but should they get any benefits from the system/product they have been promoting ? Or from recognition of the newcomers for their early involvment in helping the community ?

The deflation is a sign of the rise of trust for the system.
When less people trust/join the currency the deflation rate will go down. It will find a equilibrium.
Also, It may very well end up being in constant deflation because it is used as a supplementary currency. If we compare a inflationary currency with a stationary currency we will always find the stationary currency to be deflationary. Everything is relative.

Bitcoin will be around for a while…
This is because it actually is a great tool for payment. It is a low-cost tool for the transfer of money. With no authority involved. Great anonymity and speed.

Personally I would like to see more development in ripplepay. That system also decentralises the trust down to the individual and his/her friends. No debt gets further than one vertex away in the graph. Ripplepay is therefore much more stable in terms of trust. Bitcoin will always be subject to speculation and will be as volatile as the stock markets.

It is hard to be convinced with the basic premise of the article, and so it is hard to understand if it makes sense at all.

Specifically, a bitcoin is an equivalent of compute resources spent producing it. Like autor mentioned in the article, electronics become cheaper all the time. So mining bitcoins becomes cheaper with time.Which means, that if one hoards their bitcoins, the value of that stash goes down with the speed of computer development pace.

Which exactly points to inflation.

Now, it remains to be seen and proven, which trend – inflation or deflation has a stronger bearing in a long run. May be I missed somebody posting crystal ball.

About The Author

Rick is the founder of the first Pirate Party and is a political evangelist, traveling around Europe and the world to talk and write about ideas of a sensible information policy. He has a tech entrepreneur background and loves whisky.